Deadbeat States: Make No Mistake… Muni-Bond Defaults Are Headed Our Way

[Editor's Note: If you're a regular Money Morning reader, you know that Shah Gilani was way ahead of the crowd with his warnings about the banking meltdown, the subsequent credit crisis and even the “flash crash.” Given that, you're really going to want to hear his take on the current muni-bond-default controversy. In fact, take some time and check out this video of his recent CNBC interview, when he went head-to-head with a noted Wall Street insider over this very topic.]

Let's make one thing perfectly clear: Wall Street analyst Meredith Whitney is not crying wolf. Whitney – who gained fame for correctly predicting the U.S. banking implosion that presaged a global credit crisis – is now warning us about defaults in the $2.9 trillion municipal bond market.

Whitney is being savaged for this latest prognostication, mostly by institutional money managers who resent the way that she's roiled the traditionally sleepy "muni" market.

That's as unfair as it is ugly . It's unfair, because she's correct: muni-bond defaults are headed our way. And it's ugly because the naysayers – vested Wall Street interests that are only trying to protect their playground – are obscuring the truth.

And with this dissembling, the Whitney-bashers are keeping disadvantaged individual investors from understanding the disaster at hand, and are likely dissuading these bondholders from avoiding the locomotive that's steaming head-on at their portfolios.

Make no mistake: The so-called "deadbeat states" problem is real, and muni-bond defaults are almost certainly unavoidable.

Other Warnings

Whitney isn't a lone voice in the wilderness. Indeed, JPMorgan Chase & Co. (NYSE: JPM) Chief Executive Officer Jamie Dimon recently said that there are significant problems facing munis and technical defaults have already happened. He ought to know. Big banks like the one that he runs actually "backstop" billions of dollars of muni obligations with letters of credit that they may not want to renew.

J ust this week, the bond rating of New Jersey – a noted deadbeat state candidate – was downgraded from AA to AA- by rater Standard & Poor's Inc. According to a Bloomberg News report, S&P cited New Jersey's growing pension and healthcare obligations as the catalyst for the downgrade. And even that state's chief executive, Gov. Chris Christie, warned of the pain that's almost certain to come.

"The clock is ticking away on a pension-and-benefit bomb that can damage the health of the finances of our state," Gov. Christie, a first-term Republican, told his audience at a "town meeting" in Union City on Wednesday.

Under the Radar

The immediate, under-the-radar problem for the municipal -bond market is that borrowers relied on banks to backstop their credits and lower short-term funding costs when the credit crisis shut the door on auction-rate preferred financing.

Call it a legacy issue.

While most municipal borrowings are long term in nature, issuers still have short-term obligations that need to be rolled over. And while most of the states' ratings remained intact during the crisis, investors demanded higher interest on the money they were loaning to even the strongest borrowers. To keep borrowing costs from soaring, municipal borrowers sought big bank letters of credit (LC) as backstop guarantees on the shorter- than- they- wanted variable-rate- demand obligations that they turned to.

According to Bank of America Merrill Lynch (NYSE: BAC), $109 billion worth of different kinds of credit backstops and guarantees will be expiring in 2011. Thomson Reuters estimates that $53 billion of those guarantees are bank letters of credit.

Of course, banks charge a fee for their letters of credit. But while they will likely increase the cost of their backstops significantly, no amount of fee income may be enough if they fear being left holding the bag on obligations that face potential default.

With municipalities and issuers of infrastructure bonds – including schools districts, hospitals and sewage and garbage- collection authorities -f facing uncertain tax and revenue receipts and inevitable downgrades, the risks they pose to guarantors could shut them out from low- interest- rate borrowings.

It's not a small problem. There are 46 states – including New Jersey – that face an aggregate $140 billion in budget deficits for the 2011 fiscal year, according to the Washington-based Center on Budget and Policy Priorities. And this isn't just a one-year wonder: The need to fund the retirements of public-sector employees will linger for years and will continue to have a "negative impact" on state credit ratings, rater Moody's Investors Service (NYSE: MCO) said earlier this month.

That means that potential muni-bond defaults will be with us for a long time to come.

Rising rates on variable-rate demand obligations, which reset periodically, could be the straw that breaks the back of some muni issuers.

On top of the disdain that bankers have for increased exposure to the mounting woes of municipal finance authorities, the financial institutions face new risk-retention and capital-reserve requirements under the banking-reform law – the Dodd-Frank Wall Street Reform and Consumer Protection Act – that was enacted last July.

In the widely watched December segment of "60 Minutes" that thrust Whitney into the muni-bond spotlight, the analyst predicted that there could be as many as 100 significant defaults in the New Year – enough to total "hundreds of billions of dollars."

In January, in a subsequent interview, Whitney conceded that she had no specific numbers to back that up. But that's just part of the problem: It's impossible to tell how much exposure banks have in this shadowy realm. You can't find any breakout of their exposure to these types of letters of credit in bank financial statements. All it will take is one or two defaults to trigger write downs of their LC guarantees, which will then be followed by a loud call for transparency into what the banks are really holding.

A Calm Before the Storm

In total- return terms m unicipal bonds fell 5.4% in the three months ended Feb. 2, according to the Bank of America Merrill Lynch Municipal Master Index. Not surprisingly investors pulled $1.17 billion from muni-bond funds in the week that ended that same day (Feb. 2). That was the smallest amount since Dec. 1, according to the Investment Company Institute (ICI), but represented the latest in a string of several weeks of withdrawals.

That may well be due to the fact that Wall Street is telling investors that the drop in muni-bond prices has created the proverbial "buying opportunity." Tax-exempt bonds posted a negative return for the fifth-straight month in January, which represents the longest-such decline since a skid that lasted six months back in 1999, the Bank of America Merrill Lynch index revealed .

Just this week, in fact, Bloombergreported that Pacific Investment Management Co. and Cutwater Asset Management Corp. are "advising investors that record fund withdrawals amid projections of widespread municipal defaults have created a buying opportunity."

Shah Gilani is the Event Trading Specialist for Money Map Press. In Zenith Trading Circle Shah reveals the worst companies in the markets - right from his coveted Bankruptcy Almanac - and how readers can trade them over and over again for huge gains. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

"In January, in a subsequent interview, Whitney conceded that she had no specific numbers to back that up. But that's just part of the problem: It's impossible to tell how much exposure banks have in this shadowy realm."

So this is all speculation? There may be a problem, but we don't know how how big or small? On the other hand there may not be a problem at all?

The local radio station is running ads from "Assurity Guaranty (?) stating that they have insured the interest & principal of the bonds (insured?) so the individual is protected.

I'm tired of the exeragerations without specific credit analysis of individual credits to prove your point or Mr. Dimon's who is not an credit or municipal analysis or Mrs. Whitney who has is trying to build her firm and has venture into an arena that is not her expertise. Don't throw the baby out with the bath water. All stoks are not going to zero, all government debt is not going to default, all corporations are not going bankrupt, all cuurencies are not going to disappear, and all municipal bonds are not bad. Build your case with speciifics and not genalities. I've heard all of this before in the 70's, 80's , 90's and in the past 10 years. TThe historical record of municipal creits since the Great Depression is pretty impressive – there must be some opportunity in a $3 trillion market. Once again – it's not all negative.

Dean Lane, you are retard. this article is about cost of muni borrowing going up. as cost of muni borrowing goes up, it will hurt muni market period. as muni finance become worse, LOC and all kind of insurance cost will go up to hurt muni market.

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